Wayside Technology Group - An IT Middleman Squeezed by Competition

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Wayside Technology Group (WSTG) is a software and hardware reseller. The company operates in two segments. Lifeboat Distribution acts as a distributor, selling technical software to corporate and value-added resellers, systems integrators, and so forth. TechXtend itself is one of those value-added resellers, selling software and hardware directly to corporations, government, and academic institutions. Lifeboat's focus is helping the software vendor build distribution channels, and TechXtend's focus is helping end customers get the software they need for their IT systems.

In the end, Wayside is basically both a warehouser and retailer for business software. The company distributes technical and IT software, not entertainment or productivity. Some examples of its products are for virtualization (like VMware), networking (think Acronis), and database (Microsoft or Oracle), among others. There is a bit of concentration in the end customer base, with Software House, CDW, and Insight all accounting for over 10% of sales last year.

Wayside's business model is a retail one, with the company earning the difference between what it can acquire software and hardware from the vendor for and what it can sell it for. As you may have guessed, there is not a lot of margin there. Gross margins have historically been in the 10% range, and after marketing and corporate costs, the company has earned around 3% of sales in pre-tax profits.

Therein lies one of my two biggest issues with Wayside - I see already low profit margins contracting further going forward. For one, they are already. Gross margins have declined in each of the past 4 years, from 10.7% in 2009 to just 8% this past year. Competition and new channels of distribution are to blame. This is a business with few roads to competitive advantage outside of price. Pricing advantage is primarily driven by scale, and Wayside is a smaller fish on both the distribution and retailing sides. There are virtually no barriers to entry, and entry has actually been made easier by Internet e-commerce. Several IT solution vendors have developed direct selling programs which bypass middlemen like Wayside. The outlook isn't real positive here.

In response, Wayside has begun offering attractive extended payment terms and lower pricing to its larger customers. The upside of this strategy is that the company has indeed been able to win business - revenue was up 20% in 2012.

The downside is two-fold. First, we already mentioned lower profit margins. To illustrate the effect, while sales were way up last year, the decline in operating margin (to 2.9%, from 3.4% in 2011) actually led to a *decrease* in operating profits! Revenue growth is great, but if you can't do it profitably, does it really make sense to do it at all? I would argue no.

The second downside to extended payment terms is that it hurts cash flow. While the company can book $5.5 million in net profit on the income statement, the fact is that only $3.4 million was converted to cash, while accounts receivable ballooned 30%! In fact, we've seen this pattern over the past 5 years. The average increase in accounts receivable has been 39% per year, while operating cash flow has only averaged 53% of net income, one of the lowest rates I've seen from a profitable company over many years of analyzing stocks. What all this means is simple: Wayside is not converting its reported sales into cash at a high rate. It is an accounting red flag.

I see Wayside as a mediocre Magic Formula® choice. The firm's dividend looks enticing, with a 5% yield, but the dividend has nearly consumed all of free cash flow in each of the last 3 years. I don't expect an imminent cut, with no debt and $14 million in cash, but it is not a well-supported yield. Accounting for this, and the cash flow issue, my valuation on the shares is about $14, which is a 9% upside. That's just not much of a margin of safety given the concerns.